Pay Attention to Fees: 8 June 2023

Cascades

While I’ve written about management fees in prior blogs, it is useful to think about them again as fees can easily leave an “endowment” on the doorstep of an active manager.  A few readers will remember load funds where the cost to gain access to a fund cost 8.5%.  While those days are long gone, a reminder of that period is useful.

When investing in a load fund in the 1970s and 1980s cost 8.5%, purchasing $100 worth of a load fund ended up with an investment of $91.50.  $8.50 went to the mutual fund company.  This is why many of us gravitated to no-load funds as we wanted all our dollars working for us.

If you used a load fund, what percentage increase brought you back to even or $100?

$91.50 * X = $100.00 or X = $100/$91.5 = 1.093 or a 9.3% gain was necessary to get back to even.  In an average stock market year it took a little over a year of investing to get back to even.  Over a lifetime of investing, losing one year at the beginning creates a huge loss at retirement.

Here is another way to think about it.  The money is already yours.  Suppose the money manager is charging 1.0% or 100 basis points.  One percent does not seem all that high, but it is actually very high and here is the reason.  One famous firm that advertises in every possible medium charges 1.25% for accounts of one million dollars.  I consider that to be usury.   Don’t take the bait.

If a manager charges one percent (1.0%) management fee on the principle at the end of each year, to get back to even the manager must outperform the market by a little more than 1.0%.  What manager can do this year after year?  Which raises this question.  Ask the money manager to show you a 5-, 10-, 15-, and 20-year performance record.  Don’t settle for anything less than a 5-year record.  What benchmark are they using as a reference?  The S&P 500 is a common benchmark and it is extremely difficult to exceed it in good and bad times.

In early 1991 William Sharpe wrote a provocative article, “The Arithmetic of Active Management.”  Here is crux of Sharpe’s argument.

If “active” and “passive” management styles are defined in sensible ways, it must be the case that

1. before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and
2. after costs the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

These assertions will hold for any time period.  Moreover, they depend only on the laws of addition, subtraction, multiplication and division.  Nothing else is required.

I always smile when I recall Sharpe’s use of the word Arithmetic in the article.  He could have chosen Mathematics, but he went with Arithmetic as that implies math learned in grade school rather than the more sophisticated term, Mathematics.

Sharpe is arguing for passive index investing.  The Copernicus is exactly what he is talking about.  The Schrodinger is a close second.  The Sector BPI Plus portfolios are not too far behind as they too use index ETFs, yet there is an active management component.

Readers may well ask the question:  So why are you actively managing a number of portfolios?  Excellent question.  Protection of capital is the primary reason for active management.  Readers who have been reading this blog for a number of years have seen a gradual shift toward more and more “passive” management.  And I expect this gradual shift will continue.  I’ve always been partial to no-load mutual funds and Exchange Traded Funds (ETFs) when they first became available.  Asset Allocation has also been key with most of the portfolios.  Even the Dual Momentum™ portfolios, where one invests in a single ETF at a time ends up being more diversified than most portfolios built around the selection of individual stocks.

As passive or something close to passive management continues to flourish, expect to see more of the ITA portfolios tilt in that direction.  All ITA portfolios are very low cost.  VTI and VOO are currently charging 3 basis points or close to noise.  SPY is a little higher at 9 basis points.  ETFs in general are very low costs investments so the cost to manage any of the ITA portfolios is quite low.

Lowell

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